Investment Diversification: Is more better?

Investment Egg Basket

As mentioned in the post 5.5. Reasons Dividend Stocks Beat Index Mutual Funds, the prospect of buying a huge basket of stocks in an index fund doesn’t really provide better risk mitigation than could be had with a compact basket of 20-30 stocks – probably even fewer.  In this case, the risk being discussed is that your invested funds disappear courtesy of an unforeseen business disaster on the part of the company in which you invested.  The general premise of this piece is laid out below.

Scenario #1:  Your money is invested entirely in Company A which has a 10% chance of going out of business for various reasons.  This means you have a 10% chance of losing your entire nest egg.

Scenario #2: You split your investment portfolio evenly across Companies A and B.  Both firms are in unrelated segments like transportation and health care in which case the probability of either entity going under is independent of the other doing likewise. 

The probability of Company A going out of business remains 10% as in the first scenario.  The probability of Company B going belly up is also 10%.  What now is the probability of completely losing your shirt because both companies tank at the same time?  The companies are in unrelated industries in which case the probability of one going out of business is independent of the probability of the other going out of business.  The probability of two unrelated events happening simultaneously is determined by multiplying the probably of A times the probability of B: 

Probability A (10% ) x Probability B (10%) or .10 x .10 = .01 or 1%.

By spreading your investment pool from one company to two companies in divergent industries you’ve reduced your risk of losing everything from 10% to 1%.

Scenario #3: You think to yourself that if investing in 2 companies reduces risk, then investing in 3 companies has to be better still.  (It is, to a very small degree.)  Therefore you spread your wealth across three companies (A, B, C) each with an independent probability of going out of business of 10% because they are all in unrelated industries.  Now the risk of losing your life savings is calculated by multiplying the risk of A x B x C shown here:

Probability A (10%) x Probability B (10%) x Probability C (10%) or .10 x .10 x .10 = .001 or one-tenth of one percent.

By spreading your investment pool from two companies to three you’ve reduced your risk by nine-tenths of one percent.  The risk reduction generated isn’t large but the added workload in monitoring the third firm is, relatively speaking.

Carry this math across 15 or 20 firms and you’ll see the risk reduction becomes excruciatingly small while the management workload increases greatly in proportion.   

The math means that an index fund with hundreds or thousands of companies held within it produces no meaningful risk below that of a small, selective portfolio of quality companies as far as I’m concerned.  It does, however, generate a lot of extra work OR management fees for the index mutual fund.  Brokers and money managers like that fact.  It works to their advantage when millions of investors aren’t paying attention.

Investopedia does a nice job summarizing investment risk.  Systemic or market risk which can’t be diversified away (think inflation) and unsystemic risk which is germane to a specific company.   The unsystemic risk is what diversification is designed to mitigate.  As you can see from the examples above, the law of diminishing returns is prominent rendering moot the advantage of holding hundreds or thousands of firms in a single fund and paying a fee for the privilege of doing so.

Andrew Carnegie once said “The way to become rich is to put all your eggs into one basked and then watch that basket.”  I’m not comfortable with that advice nor am I comfortable with the current wisdom endorsing investors to put a little money into every basket and watching none of it.  Let the pros watch it for you – for a fee.  With a little work and a few tools, it’s possible you can cultivate good ground somewhere in between.  You can concentrate on solid, dividend paying companies in a diversified portfolio of 20 to 30 holdings, maybe fewer, avoid annual fees, and succeed.  It’s worth investigating, right?

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.